Chapter 10 · Macroeconomic objectives I: Low unemployment, low and stable rate of inflation
Short-run Phillips curve
Explain the short-run relationship between inflation and unemployment. Distinguish a movement along the Phillips curve from a shift of the curve.
The economic idea
The Phillips curve represents a relationship between inflation and unemployment. The short-run Phillips curve shows a possible inverse relationship for a given expected inflation rate and supply conditions.
When aggregate demand rises and the economy has some spare capacity, firms raise output and hire more labour, reducing cyclical unemployment. Increasing demand pressure can also raise wages, costs and the general price level, producing higher inflation.
Movement along one SRPC represents changing demand pressure with expected inflation held constant. A change in expected inflation or a supply shock shifts the curve, allowing inflation and unemployment to rise together or fall together.
The relationship is conditional, not a stable policy menu. Its position and shape depend on expectations, bargaining institutions, productivity, external shocks and the economy’s natural rate of unemployment.
Reading observations a to e around SRPC
“Unemployment rate” is on the horizontal axis and “Rate of inflation” is on the vertical axis. Both axes show rates, not the level of output or the price level.
“SRPC” slopes downward, so movement left is associated with lower unemployment and higher inflation, while movement right is associated with higher unemployment and lower inflation.
Points “a”, “b”, “c” and “d” are observations on the displayed short-run relationship; “e” is included to test whether a point belongs to that relationship.
Along SRPC
Moving from “a” through “b” and “c” toward “d” pairs progressively lower unemployment with higher inflation on the current curve. Reversing direction gives higher unemployment and lower inflation.
Why e matters
“e” lies away from “SRPC”. Reaching it requires a shift in the short-run relationship, not movement along the same curve.
What can shift the relationship
Higher expected inflation or an adverse supply shock can shift SRPC upward; lower expected inflation or a favourable supply shock can shift it downward. A change in the natural rate can also alter the unemployment position around which the relationship operates.
Lower inflation still means rising prices
A move from 4% inflation to 2% inflation means prices are rising more slowly, not falling. That is disinflation. Deflation would require a negative inflation rate.
The short-run trade-off holds expected inflation and supply conditions constant. If inflation and unemployment both rise after a supply shock, explain a change in the relationship rather than force the observation onto the same curve.
From aggregate demand to a movement along SRPC
Stronger aggregate demand raises firms’ sales and derived demand for labour.
Cyclical unemployment falls as output expands.
Tighter product and labour markets increase price and wage pressure, raising inflation.
This produces movement up and left along “SRPC” only while expected inflation and supply conditions remain unchanged.
What the current state establishes
“SRPC” shows that, for a given expected inflation rate and in the absence of a new supply shock, points with lower unemployment are associated with higher inflation and points with higher unemployment with lower inflation. “e” is not on the current “SRPC”, so it cannot be described as another point on the same short-run relationship.
Common mistakes to avoid
- A point off SRPC is not another choice on the same short-run trade-off.
- Correlation between inflation and unemployment does not by itself establish a stable causal policy menu.
- The vertical axis is the inflation rate, not the price level.
- Supply shocks can produce stagflation and shift SRPC rather than generate movement along it.
How to draw this diagram
- Title the diagram “Short-run Phillips curve”. Label the horizontal axis “Unemployment rate” and the vertical axis “Rate of inflation”.
- Draw SRPC first and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The curve is an analytical relationship, not a structural law that is stable across countries and time.
- Inflation expectations are difficult to observe and may be adaptive, rational or institutionally anchored.
- Supply shocks, productivity and labour-market reforms can shift the relationship independently of demand.
- Official unemployment can understate underemployment, discouraged workers and distributional differences.
- The natural rate and NAIRU are estimated with uncertainty and may change over time.